Capital Markets:II Capital Markets and the Business Cycle

Analysis of Capital Markets Aggregate Savings Aggregate Investment

Analysis of Capital Markets Aggregate Savings Households take wealth and interest rates as given and maximize utility through their choice of consumption (Savings = Income – Cons.) Aggregate Investment

Analysis of Capital Markets Aggregate Savings Households take wealth and interest rates as given and maximize utility through their choice of consumption (Savings = Income – Cons.) Rising (falling) interest rates induce a dominant substitution effect which causes current consumption to fall (rise) – that is, savings rises (falls). Aggregate Investment

Analysis of Capital Markets Aggregate Savings Households take wealth and interest rates as given and maximize utility through their choice of consumption (Savings = Income – Cons.) Rising (falling) interest rates induce a dominant substitution effect which causes current consumption to fall (rise) – that is, savings rises (falls). Aggregate Investment Firms take technology, employment, and interest rates as given and choose capital to maximize firm value.

Analysis of Capital Markets Aggregate Savings Households take wealth and interest rates as given and maximize utility through their choice of consumption (Savings = Income – Cons.) Rising (falling) interest rates induce a dominant substitution effect which causes current consumption to fall (rise) – that is, savings rises (falls). Aggregate Investment Firms take technology, employment, and interest rates as given and choose capital to maximize firm value. Decreasing MPK insures that rising interest rates will lower demand for capital.

Analysis of Capital Markets Aggregate Savings Savings is used to smooth consumption in the face of variable income. Therefore, a perceived rise (fall) in income will cause savings to decrease (increase) Aggregate Investment An increase (decrease) in productivity increases (decreases) investment demand, but the lag between purchase and installation of capital must be considered.

A Temporary Drop in Productivity

If the productivity decline is short-lived enough, investment decisions are unaffected.

A Temporary Drop in Productivity If the productivity decline is short-lived enough, investment decisions are unaffected. However, the temporary decline in income lowers aggregate savings

A Temporary Drop in Productivity If the productivity decline is short-lived enough, investment decisions are unaffected. However, the temporary decline in income lowers aggregate savings Interest rates rise while savings and investment fall

A Permanent Drop in Productivity A long lived productivity decline impacts the demand for capital.

A Permanent Drop in Productivity A long lived productivity decline impacts the demand for capital. Income is now permanently lower – savings stays the same, but consumption drops

A Permanent Drop in Productivity A long lived productivity decline impacts the demand for capital. Income is now permanently lower – savings stays the same, but consumption drops Interest rates, investment, savings, and consumption all decline

Example: Oil Price Shocks A rise in energy prices is considered to be a drop in productivity (think of MPL and MPK as net of energy costs)

Example: Oil Price Shocks A rise in energy prices is considered to be a drop in productivity (think of MPL and MPK as net of energy costs) The 1970’s saw two major oil price increases:

Example: Oil Price Shocks A rise in energy prices is considered to be a drop in productivity (think of MPL and MPK as net of energy costs) The 1970’s saw two major oil price increases: –73-’74: OPEC oil embargo raises oil prices from $4 to $10 a barrel –-’78-’79: Iranian Revolution temporarily disrupts oil production: oil prices rise from $15 to $30 a barrel. The first shock was perceived as permanent while the second was perceived as temporary

Interest Rates:

Business Cycle Characteristics Can our model of capital markets replicate the relevant business cycle facts?

Business Cycle Characteristics Can our model of capital markets replicate the relevant business cycle facts? Correlation Volatility Timing

GDP

GDP & Consumption

GDP & Investment

GDP & Gross Savings

GDP & Interest Rates

Capital Market Facts VariableDirectionTiming ConsumptionProcyclicalCoincident InvestmentProcyclicalCoincident/Leading Savings??? Interest RatesProcyclicalLagging

Can our capital market model explain these facts?

As with labor markets, the key is the price/output correlation. Specifically, remember that the interest rate is procyclical.

Can our capital market model explain these facts? As with labor markets, the key is the price/output correlation. Specifically, remember that the interest rate is procyclical. This suggests that supply side factors (ie, productivity) are behind changes in investment, savings, and interest rates.

Can our capital market model explain these facts? As with labor markets, the key is the price/output correlation. Specifically, remember that the interest rate is procyclical. This suggests that supply side factors (ie, productivity) are behind changes in investment, savings, and interest rates. Further, because investment drives the results, most shocks must be perceived as permanent.